Monday, January 6, 2014

Xero and the precious petals of New Zealand funds management

I first heard of Xero from a friend, an executive management team member of a US tech giant. [Think a direct report of the CEO of Google, Microsort, Intel or Apple or similar.] He had invested about a fifth of his (not inconsiderable) personal wealth in an obscure software company in of all places New Zealand.

Needless to say I purchased some (albeit way too little) and then investigated.

Xero is a cloud accounting software company - essentially doing what Intuit or Sage do but entirely in the cloud. Cloud software in this case obviates the need for a server, computer support or any problems with scalability.

But when I purchased the stock the valuation was absurd - the stock was trading at roughly 200 times revenue. The company also had large losses.

Our core test was to try Xero for our own business: we like it. More on the excellence of the product later.

Anyway the stock started going up fairly hard.

The next time I heard of Xero was when I met a woman from the New Zealand Sovereign Wealth Fund in Singapore. She was a charming woman born in China who disarmed me with her perfect New Zealand accent. [I used to live in Wellington New Zealand, love the place and miss the strange way they count to "six"...]

She told me that every single New Zealand fund manager they used had underperformed the index because they had not held Xero, something they thought was absurdly valued but which had gone up sharply and then up some more.

About this time three separate New Zealand fund managers contacted me (a known Antipodean short-seller) and suggested I short-sell Xero. I told at least one I owned it which somewhat shocked him. I have also had this conversation with some smaller Australian fund managers. Notably none of these fund managers had tried to use the product or had talked to anyone who did use the product. As I said, I have, and the product is life-changing good. I feel stronger about this product than (say) the first smart-phone I used.

Its a dead-easy, simple to set-up version of Intuit or Sage or MYOB. It does your accounting, links to your bank accounts and allows you to manage your transactions. The set-up makes Intuit look ungodly-complicated. And, most tellingly, it winds up superior in every way to the "in-the-server-box solution".

One example suffices.

Bronte Capital Management by law has to pay roughly 10 percent of my salary to a superannuation plan (that is a private, regulated pension plan). I chose to put it in a plan set up for me by my old employer simply because it was there and I was comfortable with the way it was invested. When setting up the payment I tested deliberately putting in the wrong bank account numbers for the recipient. The computer immediately knew I had put the wrong number in. Why? Because maybe 50 people had previously put the right number in. The error systems were crowd-sourced.This sort of thing happens all the way through Xero. The system gets better and better. Changes developed for one party who has say an issue (cross border taxation complications for instance) wind up being available for all new parties.

And the excellence shows in the growth rate for the company (revenue grows well over 100 percent) and fervour of the users. This is an accounting app and it gets Twitter comments like this:

For a New Zealand fund manager (or a short-seller) the possible end valuations of a Xero are frightening. Because of the crowd-sourcing aspects of cloud accounting there is a reasonable chance the business winds up as a sort of global natural monopoly. [This is not that unusual in technology. Tech produces powerful global natural monopolies which are vulnerable to disruptive new players with radically different technology.]

The market cap of Intuit is 21 billion. Sage is a further 6 billion. Add in MYOB (which is now private) and you get a global market cap for the sector well north of 30 billion.

But the near-monopoly cloud player should be able to capture more value than this because they also displace the servers and computer support needed for an "in-the-box" solution. My guess is that fifteen years from now there will be a totally dominant cloud accounting software company with a value north of $50 billion.

I have no idea whether Xero is the eventual winner of this game - but with the backing it has and its current head start it is as likely a winner as any. I would not want to be short this. [Long I admit is also a risky proposition. The valuation is absurd versus any current revenue or earnings metrics. This is the most expensive stock I have ever owned - and there is a reason we own it in tiny quantity.]--

Needless to say Xero stock has continued to go up and its putting New Zealand fund managers on the spot. Their underperformance has gone from notable to embarrassing.

Because they can't win this game they want to redefine victory: they are lobbying to get Xero taken out of the index. After all Xero is dramatically different from the rest of New Zealand which has an economy based on soft commodities (dairy, meat, wool and timber).

And I understand their problem. It is the problem Canadian fund managers have had. Canada has had two globally important technology companies with huge market caps and a huge percentage of the index that have imploded. These were Nortel and Blackberry respectively. The former actually went to zero having been a quarter of the index.

If a Canadian fund manager was underweight Nortel or Blackberry they had embarrassing under performance on the way up. If they were long for the collapse they had terrible absolute performance. For Canadian fund managers it was a tricky situation.

But I am not going to cede this argument to the precious (under performing) petals of New Zealand funds management. Indeed I want to argue the opposite.

New Zealand has produced many great people over the past century but until recently all the great ones had to leave New Zealand to show their greatness. Arguably the greatest three never went via Australia (Sir Ernest Rutherford, Sir Keith Park, and Sir Edmund Hillary) however most the rest went via Sydney and we claim them as Australians because it was the Australian infrastructure and social settings that allowed them to thrive. [Example: most people think that Russell Crowe is an Australian actor.]

But the internet and globalization have flattened the structure. It is possible to become a world leader and stay in Wellington or Christchurch these days. See Peter Jackson for an example. And it is possible to run a world-beating software company from Wellington too, but only if it can be funded from Wellington and only if the local market is outward focussed enough to make this possible.

Xero is not the only example. Jade is an important company based in Christchurch but it is privately held.

In arguing for taking Xero out of the index the New Zealand fund managers are demanding that the globally aware outward looking and creative people leave New Zealand to get funded.

As an Australian I like that idea. The best of New Zealand talent will continue to come here to our great benefit. Kiwis can (vainly) claim them as their own - but it won't matter. Their economic contribution will be to Australia.

What the New Zealand fund managers are arguing for is an insular old New Zealand. A startlingly beautiful but somewhat backward place for Australians to visit when we can bother to put up with the inferior Kiwi weather.

My recommendation

Those that determine the mix of the New Zealand index should simply ignore the hurt-feelings and lame excuses of under-performing fund managers.

And to the Sovereign wealth fund. If your fund manager had underperformed the index because they did not own market weight in Xero (ie all of them) and they have not explored the software extensively themselves fire them. You should also fire them if they have argued for removing Xero from the benchmark. They are representative of the old, inward looking New Zealand that you should be leaving behind.

John

PS. At the rate the New Zealand tech industry is growing, especially with companies like Xero, there is a chance than Kiwis will start to see Australia as a slightly backward place with good beaches and sunny weather. Personally I like it when the really entrepreneurial Kiwis come here. So maybe, for Australia's sake, I should reverse the recommendations above.

For accuracy sake: there is no such thing as a NZ Sovereign Wealth Fund, but there is a large managed government pension fund which - to confuse anyone not from the Antipodes - is called a "superannuation" fund.

If your fund manager had underperformed the index because they did not own market weight in Xero (ie all of them) and they have not explored the software extensively themselves fire them.

That's harsh and surprising. They have underperformed in the short-term, just as Buffett did in the TMT boom. You are arguing that fund managers should not diverge from the index too much, and a parochial index at that. I prefer my managers to have the courage of their convictions. If they have a value style then would they buy a rocket growth stock?I don't think Buffett would have bought Xero even if were a Kiwi.That fact that Xero has shot out the lights doesn't make you right for buying it. It could have failed, it may still fail. What if Google used its crowdsourced data to make an accounting system? They may already have a critical mass of data in accounting as a jump start.

XRO is the greatest company Aust fundies have never heard of. This largely reflects a laziness amongst the funds management community to be proactive. [Apologies to the few that do go above and beyond but there is only a handful of you].

In fact, most have never heard of Peter Thiel either. It's a shame as he is one of the greatest value creators in the last 30 years. Consider that some of the companies he either founded or seeded include PayPal (bought by eBay for US$1.5bn), Facebook (US$140bn market cap), LinkedIn (US$24bn market cap), Palantir (US$8bn market cap), Stripe (~US$300m valuation), Xero (A$4bn market cap), etc...

Locally, while fundies busily debate WES v WOW or DJS v MYR, they are missing the point that the game has shifted. In retail for example, drop shipping, 3D printing, 3 hr fulfilment, augmented reality, embedded payment systems pose a greater threat to retailers like DJS and their 25 year old beige PoS terminals than weather, purple jackets or Myer's Jennifer Hawkins parading at Spring Carnival.

Australian and NZ fund managers have missed the Xero opportunity. US investors will not do the same. Luckily, there is a pipeline of amazing up and coming companies set to emerge in in both here and in NZ. It will be interesting to see which fundies are incentivised to do the work.

The argument that Xero has a better chance to become a natural monopoly is weak. Being cloud-based doesn't make Xero more likely to be a monopoly than a shrink-wrapped package like QuickBook. There is nothing stopping Intuit from implementing the kind of cloud-sourcing mechanism you mentioned in QuickBook in its current form. Both cloud-based s/w and fat-client s/w can do it.

The way I see it, be it cloud-based or shrink-wrapped, the marginal cost of a s/w is still (virtually) zero. The economics of cloud-based s/w *to the suppliers* is no difference to shrink-wrapped s/w. (The economics of cloud-based s/w to the customers is different though, as they don't have to maintain their IT infrastructure. But that's not your argument.)

If so, your argument is reduced to "Xero has better features". But we know better that having better features doesn't automatically win this game.

I see a competitive environment in the ENTRY LEVEL accounting software space where Xero play (your assumption that there will be one global winner overlooks the regional nature of accounting and payroll which has prevented a global monopoly in this space to this point - Intuit own North America, but struggle in APAC for example).In a competitive environment PRICE will play a part at the level of the market Xero target. Xero is built on Microsoft technologies (.net and MS SQL) and is hosted on Rackspace. They have a large and increasing cost base to these 2 companies before you even account for R&D and staffing costs. They are open to serious price competition from players such as Wave Accounting and others who can leverage lower cost bases (using open source or other technologies).And don't discount the sleeping giant Intuit. They actually have the headstart (been ding QB online for longer than Xero), they actually make a profit, have a massive loyal client and channel base.Xero IS overvalued. The current share price is 10 years best scenario in my opinion . Fund managers are right to avoid the bubble, its just the new tulip mania. It is the same reason fund managers don't take their clients money and walk into a casino or racetrack. There are significant risks with Xero's current valuation.

John, check out another smart entrepreneur Scott Bradley from Vmob (VML.NZ) . The competitive advantage NZ has is that there is only a small resources industry to cause the brain drain away from tech. Further, kiwis must think global given the size of the local market where Aussie's can do OK within the local market.

I don't buy the regional argument, my businesses are in London and Australia, both use Xero. It wasn't because I was familiar with the product, but because it had the best muticurrency income features.

John, I didn't see what % of the market Xero represented. I think Nortel got up to 30%, but am not sure what B'berry hit. Since Nortel, I suspect most pension funds etc, have all limited the max % of a stock to, say 10% of the portfolio as a part of the mandate requirements.

John - MYOB is private but thanks to their issuance of subordinated debt on ASX (news code MYB: ASX) you can see their metrics. They have grown nicely post provaisation. I am short XRO in a small way but there is no stock lending available at present - there was in early November - which probably accounts for the recent gains from A$27 back up to $32ish. As for the suggestion by a poster that no one had heard of Peter Thiel - wonder why the stock went from $18 to $30 in a month post the placement!!! Main issue is obviously valuation but its interesting how attempts to lift prices in 2013 met with quite some resistance. I'm intruiged that there was some apparent price elasticity.

I think the company has a shot at being successful but the big test is coming in US and UK. You can see some tapering in the home markets already. The valuation at this stage is discounting a chunk of that success and Intuit, MYOB and Sage being fast asleep.

If a child emigrates from India with his family at age 4, and I insist he's not Australian but Indian, I'm rightfully called racist. Rusty has deserved the right to be called an Aussie if he wishes. There are better examples of Kiwi upstarts moving in their 20s and 30s, though perhaps less famous.

Interesting company but valuation and stock price prediction is a crap shoot. But good to keep an eye on.

Sometimes when you are too close to the action you dont see the forest for the trees. Fund managers miss this all the time, especially in more conservative commonwealth countries. But then again they tend not to blow up thier banking systems every 10 years either....

"After all Xero is dramatically different from the rest of New Zealand which has an economy based on soft commodities (dairy, meat, wool and timber)."

Now this statement alone should tell you that the vast majority of New Zealand fund managers have no business analyzing the stock of zero. It's great that you have high-level management sources at US tech companies. How many NZ fund manager have that John? Your argument basically is that because the stock is in New Zealand any fund manager should have looked at it and been able to determine it was a good idea. I have no view on xero, but I strongly disagree with your premise. That said I could care less what they put in the index - anywhere...

Since Nortel, I suspect most pension funds etc, have all limited the max % of a stock to, say 10% of the portfolio as a part of the mandate requirements.

This was also the problem for Finnish fund managers in the Nokia era. In actual fact, I think both John and the NZ fund munugers have a point. You can't play around with the indices to suit someone's performance statistics, and you can't have a tech company with no earnings as 10% of your portfolio no matter what the index says.

I think that the solution might be some program of education, to give New Zealand yet another global edge, by making Kiwi punters the first fund management market in the world to understand that you can't select funds simply by looking at the 3 year returns number and seeing if it is bigger or smaller than the 3 year index performance number.

FWIW lets have a stab. Assumptions all in Kiwi$:Market cap $4.9billion as at todayAssume no debt or cash by "maturity" - define that how you want$350/customer annual revenue - consistent with last three half yearsEBITDA margin at maturity of 75%,(MYOB is circa 50% and reasonably expenses R&D) EV/EBITDA multiple at maturity of 20x - plausible

A bit of backwards engineering says that to justify this market cap they need around 938,000 customers versus 211,000 at Sept 13; they are adding at circa 55,000 per half year. If you dull the Ev/EBITDA to 17x at maturity, they'd need about 1.25million customers at that $350pa level. Because it's so rudimentary, no discount for time value of money etc. As a guide, MYOB has 1.2m business customers who generate $195pa revenue BUT that's non comparable because of the one off buys. However, over a third of new small biz customers use AccountRightLive and they acquired BankLink last May to provide the type of linkage you talk about. A doubling of the enterprise value from early 2009 of MYOB would take EV to $1bn - about 9x EV/EBITDA (PE paid $401 equity $16 debt and $78 of dividends) plus say A$100m additional they paid for BankLink. That's probably a bit low - I reckon on a public float MYOB might go for EV/EBITDA around 11-12x for an EV around $1.2 - $1.3billion. MYOB now has $680m of debt inlcuding unearned revenue so plenty of scope for PE to do some capital rearrangement. So at current prices we're saying XRO is worth nearly 4x the incumbent market leader in Aus and NZ which are XRO's key markets at present. I totally accept the global opportunity, but that's available to new MYOB as well and XRO have hardly started in UK and US. I am modestly short XRO and bow in admiration to the power of your posting John - a mere 18% or over $700million in four days....!

John, Sitting in the US and learning about Xero first as a user and then as an investor, I really appreciate how much heard thinkers fund managers are.

I think that hedgies (as they are called in the US) are starting to make up for their mistake by investing in Wynyard. I'd like to see a post by you why Wynyard is not Xero (which start up, capped at the time around $65M buys IP from its former, privately held, high ownership crossover company IP rights for $23M?). If there is a short in SaaS because of a bubble, here you go.

This post brings to mind the quote by Robert Muldoon "New Zealanders who move to Australia raise the IQ of both countries".

Xero does seem good but the social media posts praising it have a very similar style which usually implies they are fake. At least in the US very few real small businesses actually use Twitter. Twitter has almost no penetration amongst real people except for the African American community and even then it seems almost exclusively a male phenomenon. Twitter is almost exclusively marketers talking to each other.

Interesting article!But just a question: I do not really understand the index-problems of an unusually good performing stock. It is that unusual to limit the max influence of a single share in an index?For the German DAX-Index there is a cap limitation (Kappungsgrenze) at 10% per share. So if a stock performes unusually good, its influence is cut to max 10% in the quateryearly sessions.

should have said Reckon (ASX RKN) a better short inverting the XRO a good long hypothesis. With free cash flow stagnating around 10cps and dividend at 8 cps, and the potential for market loss to XRO its PE of 14 might be a bit rich. Only 0.13% of the stock sold short according to ASIC so not heavily shorted.

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